HOW INNOVATION REALLY

WORKS
SUMMARY OF THE BOOK “HOW INNOVATION REALLY WORKS”
BY
ANNE MARIE KNOTT

THIS RESEARCH IS SPONSORED BY NSF

2017
 According to NSF:
• Basic research is a systematic pursuit of
new knowledge without specific
immediate commercial application.
• Applied research is a planned, systematic
DEFINITION pursuit of new knowledge aimed at
solving a specific problem or meeting a
specific commercial objective.
• Development is the systematic use of
research and practical experience to
produce new or significantly improved
goods, services or processes.
 • In the US, in 2016 top 1000 R&D spenders invested USD 680 billion
in R&D up 5% from the prior year. 63% companies are overinvesting
and 33% are underinvesting in R&D.
• Less than 5% of startups obtain Venture Capitalists financing, and
of those that do, only 25% return their investment capital. So when
we think startups, we are likely ignoring 98.75% of companies.
• The money companies spend on R&D is producing fewer and fewer
results. In fact, the return to companies R&D spending have
declined 65% over the past three decades. Only 2 out of 125 R&D
DATA/FACTS projects reached its commercial success.
• According to Business R&D and Innovation Survey (BRDIS) 3.4% of

ON R&D outsourcing R&D is to universities, 81.3% is to companies, and the

remaining 15.2% is to government agencies and other institutions.
• Large companies differ from small companies is that they conduct
more basic research. The vast majority (82%) of R&D in companies
is development.
• Small companies invest less in R&D. Bill Gates did not develop DOS,
he bought it for USD 50,000 from Seatle Computer Co. Similarly,
Steve Jobs imitated the Graphical User Interface after seeing it at
Xerox PARC and hiring employees who had formerly worked at
PARC.
 • There is no question that innovation is
important. Innovation is key to companies
growth. R&D has been viewed as engine of
economic growth.
• Despite the importance of innovation to
companies as well as to the broader economy,
despite the growth in real R&D by both the
government and companies, and despite all the
FLYING BLIND expert dedicated to helping companies
innovate, companies have become worst at it.
• The return to companies R&D spending have
declined 65% over the past three decades and
coincidentally this decline coincides closely with
the decline in US GDP growth over the past 30
years.
• This book propose Research Quotients (RQ)
solution.
 • MISCONCEPTION 1: Small Companies Are More
Innovative
• MISCONCEPTION 2: Uncontested Markets Are Good
for Innovation
• MISCONCEPTION 3: Spending More on R&D
Increases Innovation
MISCONCEPTION • MISCONCEPTION 4: Companies Need More Radical
Innovation
• MISCONCEPTION 5: Open Innovation Turbocharges
R&D
• MISCONCEPTION 6: R&D Need to Be More Relevant
• MISCONCEPTION 7: Wall Street Reward Innovation
 • The fact shows that large companies are more innovative than
small companies.
• Large companies have scale and scope of economies that allow
them to better generate and exploit innovation.
• These advantages cause large companies to favor incremental
and process innovations because these forms of innovation
benefit more directly from the scale advantages.
• The source of misconception: (1) People confuse small
companies and young companies, and indeed companies are
MISCONCEPTION 1 more innovative when they are younger; (2) People only see
Small Companies Are the successful young/small companies and overlook the other
98.75% of startups that fail to receive Venture Capitalist (VC)
More Innovative funding and to return at least the invested capital.
• Large companies are the chief of engine of innovation. Not
only large companies conduct 5.75 more R&D in aggregate
than small companies, they have 13% higher productivity with
that R&D.
• A further benefit of large company R&D is that it generates the
spillovers upon which small company innovation free-rides.
 • The fact shows that Blue Ocean Strategies lead to high profits,
but low levels of innovation.
• The return to this monopolists innovation are low because
ultimately they reach a point where they have brought all the
profitable customers into the market. The remaining customers
require either extremely low price or an extremely high level of
performance.
• Once the monopolist reaches that point, the cost to bring in
additional cutomers exceeds the profits from those customers.
MISCONCEPTION 2: • Lack of innovation makes the monopolists market attractive to
Uncontested Markets Are new entrants.
Good for Innovation • While such monopolists need to be vigilant that natural
incentives do not work against their innovating, they need not
be doomed. They can create competition for themselves to force
innovation such that to form of creating future clones, where the
company both innovates and continous to enjoy monopoly
profits.
• For companies to remain innovative, the most straightforward
strategy is to seek out Porters “4 Diamonds” markets that makes
companies continously innovate because their life depends on it.
PORTERS 4 DIAMONDS
 • Tax credit indeed increase investment on R&D but it
won’t solve the problem of increasing innovation and
growth. The fact of the matter 63% of companies are
already overinvesting in R&D.
• For 33% of companies that are underinvesting should
not need tax credits to increase R&D. Increasing R&D
will increase their profits even without tax credits.
• Shareholders in companies that are overinvesting on
MISCONCEPTION 3: R&D increase the value of their stock by having those
Spending More on companies cut overinvestment.
R&D Increases • Shareholders in companies that are underinvesting on
Innovation R&D increase the value of their stock by having those
companies increase their R&D.
• These corrections increase companies profits, the
government gains corporate income tax on the higher
profits and capital gains tax on the additional
shareholders wealth. So the government increases
revenues and saves the tax credits.
 • Large companies, those with central labs doing basic research,
are going to generate the seeds for most radical innovations.
• These radical innovations will typically have lower returns than
more incremental innovation, and thus will be part of 123 of
125 projects the company abandons.
• In some cases, startups will exploit these innovations. Thus,
small companies will be disproportionately associated with
MISCONCEPTION 4: radical innovation, even though the underlying technology for
the innovation is likely to have originated in a large company.
Companies Need More
• While most of those startups will fail to recoup their initial
Radical Innovation investment, those that succeed will have outsized returns.
Microsoft and Apple are very good examples.
• Large companies get higher returns, entrepreneurs have a stock
of abandoned innovations to exploit, and the economy gets
radical innovations.
• Is there a way for large companies to better capitalize on the
123 projects they abandon? The answer may be yes.
 • There is a widely belief that open innovation increases companies
financial performance.
• Accordingly, open innovation has been adopted by the vast majority of
companies engaged in R&D, there has been a 2050% increase in the
amount of outsorced R&D.
• There is some evidence that open innovation in the form of idea
sourcing may improve companies financial performance, the record on
MISCONCEPTION 5: idea development indicates that R&D outsourcing not only fails to
improve financial performance but it actually degrades it.
Open Innovation • This occours because outsourced R&D incurs R&D expenditures
Turbocharges R&D without increasing revenues. Thus it decreases profits. Worse, however,
it appears that outsorcing R&D is a slippery slope wherein company
innovative capability decays, so the company increasingly outsources,
and capability decays even further.
• These mechanics are so powerful that outsorced R&D accounts for
much of the 65% decline in R&D Quotients. If companies are willing to
undertake the investments to recreate labs and rebuild their technical
staffs, over time they should be able to restore RQ to prior levels.
 • In 1980s and 1990s a number of economic forces
led to widespread decentralization of R&D. The
logic of decentralized R&D is that it makes
companies more responsive to the market.
• 80% of consultants and 90% of investment
professionals believed decentralized R&D is
associated with higher RQ. In fact the opposite is
MISCONCEPTION 6: true: companies with centralized R&D have 40 %
R&D Need to Be to 64% higher RQ than companies with
More Relevant decentralized R&D.
• Centralized R&D tends to: (a) do more basic
research, so are more likely to create new
technical possibilities; (b) create technology that
benefits multiple divisions, and (c) derive more
of their technology from internal R&D rather
than through outsourcing.
 • The Wall street reward companies growth not
innovation.
• The first way RQ helps companies is by telling
them how much they should invest in R&D.
However, if investors do not know how the
increased investment translated to market value,
companies may not have discretion to expend
MISCONCEPTION 7: additional funds.
Wall Street Reward • Fortunately RQ defines the relationship between
Innovation companies R&D and their market value. So
investors should know companies RQs to check
wether companies overinvestment or
underinvestment on R&D.
• By knowing RQs investors play critical role in
restoring economic growth even though they do
not invest in R&D directly, they influence the
behavior of companies that do.
 THE RESEARCH QUOTIENTS (RQ) SOLUTION
The production function:
Output = CAPITAL x Labor ................................................................ Eq. 1

The production function to generate RQ:

Output = CAPITAL x LABOR x R&D x Spillovers x Advertising ............ Eq.2

For company i, the Eq.2 become:

Output = CAPITALi x LABOR i x R&D ix Spillovers i x Advertisingi .......... Eq.3
The definition of RQ is the “company-specific output elasticity of R&D (i in
Eq.3)
 THE RESEARCH QUOTIENTS (RQ) SOLUTION
From Eq.2
Profits = (CAPITAL x LABOR x R&D x Spillovers x Advertising)- Costs

Profits = (Gross margin) x (CAPITAL x LABOR x R&D x Spillovers x

Advertising) - R&D

Ri* = (i CAPITAL LABOR Spillovers Advertising e 0 )1/(1-)

R* : Optimal value of R&D merupakan derivatif dari Profits terhadap R&D.

CORRELATION BETWEEN RQ AND TFP
CORRELATION BETWEEN RQ AND PATENT INTENSITY
 • RQ is the most powerful measure you can
construct for a company’s innovativeness. It is
derived from economic theory, and more
important, its behavior matches proposition
from economic theory when tested over 47
years of data. RQ predicts R&D investment,
market value, and revenue growth.
• RQ also has properties that make it useful to
CONCLUSION companies. RQ is uniform, it is essentially a
ratio of output to inputs, so it can be
compared across busines units.
• RQ is valuable tool for (1) justifying R&D
investment to CEOs, the board and investors;
(2) improving the efficiency of R&D; (3)
estimating the value of R&D investment to
future growth.